A wave of turmoil is sweeping through government bond markets across the world, setting off the most dramatic moves of recent years and threatening to spill over into over-heated equity markets.

Yields on German 10-year Bunds spiked violently by almost 20 basis points to 0.78 per cent early yesterday as funds scrambled to unwind the so-called “QE trade” in Europe, with powerful ripple effects reaching Japan, Australia, Brazil and even US Treasuries.

“This is the beginning of a buyers’ strike for bonds,” said David Baskin, president of Baskin Wealth Management in Toronto. “You’re getting no capital gains on some of these things now, and people are starting to finally wake up to the absurdity of it.” Keep reading. [/np_storybar]

“It is pandemonium in the fixed income markets,” said Andrew Roberts, head of European credit at RBS. “Everybody has been trying to get out of long-duration positions at the same time but the door is getting smaller.”

German yields fell back just as fast to 0.58 per cent later as bargain-hunters came back into the European debt markets but are still unrecognizable from the historic lows of 0.07 per cent just two weeks ago.

Ructions of this magnitude are rare in the government bond markets. Investors are nursing almost half a trillion dollars in paper losses in two weeks, a staggering sum in what is supposed to be a rock-solid repository for institutional investors.

French, Italian, Spanish, and Portuguese bonds have all sold off sharply over the past two weeks, obliterating the gains in yield compression since the European Central Bank unveiled a bond purchase programme of euros 60-billion a month in January.

People got too exuberant and they’re coming back to reality

“Anything over-populated is being cleared out. People got too exuberant and they’re coming back to reality,” said David Bloom, currency chief at HSBC.

Peter Schaffrik from RBC Capital Markets said rising yields can be a healthy development if the global economy is picking up speed. It is a different matter if they suddenly jump at a time of sluggish growth and disappointing figures in the US.

“It is potentially dangerous. What worries me is that we don’t have a good macro-economic back-drop driving yields higher. We don’t see a reflationary recovery,” he said.

Investors already face a changed world from early April when deflation was still on everybody’s lips and Mexico was able to sell euros 1.5-billion of 100-year bonds at a rate of 4.2 per cent.

The worm turned two weeks later when bond king Bill Gross from Janus Capital declared that Bunds had become unhinged and were the “short of a lifetime”, quickly followed by warnings from Berkshire Hathaway’s Warren Buffett that bonds were “very overvalued”.

The sharp moves have been exacerbated by lack of liquidity as traditional dealers withdraw from the market to comply with stricter rules. The Institute of International Finance said this week that thin liquidity had become the top issue in talks with central banks and regulators. It said the new rules amounted to a “dramatic revolution” that had re-engineered the global financial system and pushed risk out into the shadows, storing up outcomes that are likely to be “pretty painful and certainly unknowable”.

Global bourses have so far shrugged off the bond market crash but this is untenable over time and there are already signs of jitters as the spring rally runs out of steam. Equity prices and bond yields tend to feed off each other, though the relationship is not always mechanical and there can be time-lags.

Janet Yellen, chairman of the US Federal Reserve, issued an implicit warning that Wall Street has got ahead of itself and may be vulnerable to monetary tightening. Markets have priced in a far slower pace of rate rises over the next 18 months than the Fed itself.

Confusion now reigns in financial markets. Brent oil prices have surged by over 30 per cent since January to US$67 a barrel and copper futures have risen in lockstep, normally a sign that the global economy is coming back to life and that inflation will follow in short order. The broad M3 money supply has been growing at a brisk rate on both sides of the Atlantic, reaching an annual rate of 7 per cent in the eurozone over the last six months.

Yet closely tracked indicators for inflation expectations – such as the “5/year 5/year forward rate” – remain depressed, especially in Europe. “There is no global reflation story. If I were able to find it, I’d be doing cartwheels down the dealing floor but it is not there,” said HSBC’s David Bloom.

Investors piled into EMU sovereign debt late last year and in early 2015 in the belief that the ECB’s bond blitz would soak up the available supply, leading to a scarcity. Bunds became the favourite trade as the German government prepared a budget surplus of 0.5 per cent of GDP this year, eliminating roughly euros 18-billion of existing bonds.

This degenerated into a momentum trade. German yields continued dropping below zero as far out as eight years maturity, even as the deflation scare abated and Europe began to eke out modest growth. “We are seeing the unwinding of an enormous bull rally in the bond markets,” said Anthony O’Brien from Morgan Stanley.

“There was some complacency and a lot of lazy longs and bond prices have tumbled, but we don’t think this is enough to snuff out recovery,” he said.

If Friday's gains are anything to go by, investors are champing at the bit

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